G-20 leaders must face up to period of contraction

The Business Times
Published November 20, 2008
G-20 leaders must face up to period of contraction

By ANTHONY ROWLEY
TOKYO CORRESPONDENT

WORLD leaders keep insisting that their first priority in dealing with the economic and financial crisis is to 'restore growth' - whether by monetary or fiscal means, or both. Yet, it will need stimulus on a truly massive scale to compensate for the colossal loss of real and paper wealth unleashed by the financial implosion which is now destroying spending power, consumption and economic activity around the world.

By making such claims, as they did at last weekend's G-20 summit meeting in Washington, leaders hope to demonstrate statesmanship. Yet, it is cruel deception to encourage anyone to believe that the growth switch can be thrown back on once the fuse has been mended, so to speak, and that light will then be restored. We are almost certainly in for a long period of economic gloom if not exactly a new dark age.

To get this in perspective, think of the untold trillions of dollars wiped off the value of real estate, stock markets, bank loans and other tangible or financial assets since the sub-prime mortgage crisis erupted. Admittedly, much of this was 'paper' wealth, but it provided collateral for easy credit from banks and other lending institutions to finance an orgy of consumption in the United States and elsewhere. That spending called forth a matching surge in production of goods and services, which in turn propelled economic activity to boom levels and created high employment for those fortunate enough to have jobs.

Advanced and some emerging economies alike shared the prosperity as the process of securitisation propelled credit creation to new peaks by destroying direct contact between lenders and borrowers. By contrast, fiscal stimulus announced so far by governments amounts to not much more than US$1 trillion. To take this figure up to a level where it would match the amounts lost would require fiscal stimulus big enough to bankrupt many governments. Or, it would need the money printing presses to be running at a rate that would induce heart failure among central bankers. Even if the latter course were adopted - which is all but unthinkable - there would certainly be no guarantee of a resumption of economic activity to anything like pre-crisis levels. As they say, you can 'lead a horse to water but you cannot make it drink'. The consumer - whether in the US, Europe, Japan or wherever - is in defensive (saving) mood and the days of conspicuous consumption are over. Despite a cursory nod in the direction of Japan's post-bubble economy experience, policymakers appear to be ignoring the basic lessons that Japan can teach. These are that once a nation's financial system is broken, you can pump money into it for all you're worth (and more) but it won't reach the parts you want to get it to.

Another is that fiscal stimulus big enough to compensate for the bursting of a monetary bubble also tends to 'break' the government - witness Japan's government debt to GDP ratio of over 150 per cent. Growth will be restored at some point, but it will have to be from a much lower base of economic activity than that at which leading economies went into recession.

In the meantime, the most that national leaders should realistically be promising is to cushion the fall as best as they can. To claim, as many of them are doing, that the right thing to do is to spend now and worry about government deficits later is dangerous and is courting the kind of chronic deficit problems that Japan now has even after nearly 20 years since its bubble burst. Likewise, to pump money too heavily is to court first the danger of a 'liquidity trap' and later of hyper-inflation. This is a gloomy prognosis, yet realistic. A long period of credit-based economic expansion of the kind we enjoyed until now must be matched by a suitable period of contraction if the system is to be purged of excess. This may not be the message that would make national leaders loved but it would probably make them respected. Consumers know they have binged too much, even if they could not help themselves.

Another way in which some G-20 leaders were fighting yesterday's battles rather than tomorrow's when they met in Washington was by focusing so much on financial regulation. This is like locking the stable door not just after the horse has bolted but after it has lost all desire to flee.

The 'animal spirits' that drove the excesses leading up to the current crisis have been curbed already by the financial and economic collapse and we would be better off trying to find ways of dealing with the resulting threat of deflation. Some G-20 heads, including US President George W Bush, were also busy demanding that 'free market principles' be preserved in any reforms enacted in the wake of the crisis. Rather ironic, really, seeing that not only have Wall Street institutions crumbled ignominiously as a result of their own errors but also Detroit's car giants are poised for collapse now that the credit machine is broken. Should the market be saved from its own failures?